Pegged Exchange Rates: The Pros and Cons

Many countries prefer to peg the value of their currency to the value of another currency known for its relative stability. This can protect a nation's economic interests and give its exported goods the comparative advantage of a lower price.

The practice has disadvantages, including a requirement for maintaining large capital reserves and a potential vulnerability to inflation.

Pros of a Pegged Rate

By controlling its domestic currency, a country can in most circumstances keep its exchange rate low. This makes its exports cheaper and more competitive abroad.

The real advantage is seen in trade relationships between countries with low costs of production, like Thailand and Vietnam, and economies with stronger comparative currencies, like the U.S. and the European Union.

When Thai and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate.

Thus, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home.

Currency Protection

The fixed exchange rate tends to support a rising standard of living and overall economic growth. But that's not all.

Governments that adopt a fixed, or pegged, exchange rate are protecting their domestic economies. Foreign exchange price swings have been known to adversely affect an economy and its growth outlook. By shielding the domestic currency from volatile swings, governments reduce the likelihood of a currency crisis disrupting the lives of their people.

After a short couple of years with a semi-floated currency, China decided during the global financial crisis of 2008 to revert to a fixed exchange rate regime. The decision helped the Chinese economy to emerge two years later relatively unscathed. Other industrialized economies with floating rates turned lower before rebounding.

In June 2010, China's government ended a 23-month peg of its currency to the U.S. dollar. The announcement, which followed months of commentary and criticism from United States politicians, was lauded by global economic leaders.

Today, China continues to operate with a pegged currency that is actively managed against the value of a basket of currencies.

Cons of a Fixed/Pegged Rate

Governments pay a price for implementing a pegged-currency policy. A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves, as the country's government or central bank is constantly buying or selling the domestic currency.

The problem with maintaining huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects—notably higher inflation. The more currency reserves there are, the bigger the monetary supply, which causes prices to rise. Rising prices cause havoc for countries that are struggling for stability.

Example: Thailand's Baht

Nations with a pegged currency are better able to defend themselves against adverse global situations. But they tend to be exposed to domestic economic problems.

Many times, indecision about adjusting the peg for an economy's currency can be coupled with the inability to defend the underlying fixed rate. The Thai baht was one such currency.

The baht was at one time pegged to the U.S. dollar. Once considered a prized currency investment, the Thai baht came under attack following adverse capital market events during 1996-1997. The currency depreciated and the baht plunged rapidly because the government was unwilling or unable to defend it due to its limited reserves.

In August 1997, the Thai government was forced into floating the currency before accepting an International Monetary Fund bailout. Even so, between July 1997 and January 1998, the baht fell by as much as 56%.

Today, the Thai baht remains an unpegged currency. Its economy has strengthened considerably, with a shrinking poverty rate and a growing manufacturing base.

The Bottom Line

Pegging a currency is most attractive to nations with rapidly-developing economies and those that are highly dependant on foreign trade. While it's not foolproof, a currency peg tends to keep a nation's products competitive in foreign markets.